The first half of 2023 has brought some reprieve from the dollar’s one-way march higher, to the delight of many emerging market equity investors, but what will the second half bring? Let’s look at a couple of themes that may shape its path forward for the remainder of 2023.
When will the Fed stop hiking interest rates?
The Fed‘s interest rate policy has been a major source of the dollar’s gains. Since March 2022, the Fed has hiked the federal funds rate—the rate at which banks borrow cash held at Federal Reserve Banks from one another—an astonishing 10 times, desperately trying to bring down the overall rate of inflation. These moves have pushed the rate from near 0% in early 2022 to more than 5% today, the fastest increase since the great inflationary episode of the 1970s and early ’80s. This has driven marginal flows into the dollar, bidding up its price as international investors have sought out the highest returns they can find.
Cumulative change in federal funds target rate (midpoint of range)
Sources: Bloomberg, Federal Reserve, 5/23/2023. For illustrative purposes only.
Having acted aggressively, the Fed now finds itself in a bit of a pickle. US inflation has come off the boil but still sits uncomfortably high relative to the Fed’s long-term target of 2% average inflation. It’s well known that policy moves take effect with long and variable lags, meaning the cumulative impact of interest rate hikes is likely yet to take effect in earnest. And with the regional banking crisis still on the minds of many, it seems probable the Fed might take a breather from rate increases for a while. The market seems to have reached the same conclusion: Pricing in the fed funds futures market suggests that interest rate cuts could be in the cards later this year, undoubtedly a reflection of some concern that economic activity may wane.
On the other hand, recent economic data remains strong. The economy continues to add jobs at a robust pace, picking up an average of 330,000 per month over the past 12 months. Unemployment remains near a 50-year low, and unit labor costs have continued to run above average, which could put pressure on inflation going forward. The Fed has its work cut out for it. Regardless of where the economy goes from here, it seems unlikely that the recent pace of interest rate hikes will continue, which could lead the dollar to meet some selling pressure in the near term.
How will geopolitical risk affect the dollar?
The bottom line